I’d like to share with you a quick primer on fraud.
You can engage in fraud by intentionally misrepresenting a “material fact," knowing it is false and that the person to whom it is made will rely on it. If I am selling you my home and tell you it recently passed a termite inspection, knowing there was no inspection, I am engaging in fraudulent conduct. If I don’t tell you my home is infested with termites, I have failed to state a material fact and engaged in another form of fraud (a “fraudulent omission”).
Fraud in the securities industry is governed by Rule 10b-5, promulgated by the U.S. Securities and Exchange Commission, under Section 10(b) of the Securities Exchange Act of 1934. It sets forth conduct deemed fraudulent in connection with the purchase or sale of securities. As such, it governs the conduct of mutual funds, brokers and registered investment advisors, or RIAs.
The conduct prohibited is the making of "any untrue statement of a material fact" or the omission of a "material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading." There is also a general prohibition against any "act, practice or course of business" that operates as a fraud or deceit upon any person in connection with the purchase or sale of any security.
Engaging in criminal fraud. Some conduct is easily recognizable (albeit after the fact) as constituting criminal fraud. The most egregious example in recent history is the Ponzi scheme perpetrated by Bernie Madoff. Other conduct that can constitute criminal fraud is insider trading. This occurs when those with confidential information about significant events affecting the price of the stock then trade the stock, without disclosing that information to those on the other side of the trade.
What is surprising about fraudulent conduct in the securities industry is how common it is. The SEC regularly reports of a new action for criminal or civil fraud against an institution. The Federal Bureau of Investigation has a helpful list of the various types of securities fraud on its website, along with tips about how to avoid becoming a victim.
Recommending expensive index funds. What if you were in the market for a new car and visited two dealerships? Both showed you the exact same make and model. The only difference was price. The price at one dealer was 15 percent less than the price at the other dealer. Your decision would be simple: You would purchase from the lower-priced dealer.
Now let's assume you want to invest in an index fund that tracks the Standard & Poor's 500 index. You go to a broker who recommends the State Farm S&P 500 Index B Fund (SNPBX). He or she explains that this fund seeks to achieve investment performance similar to the S&P 500 index. The broker doesn't tell you that the expense ratio for this fund is a whopping 1.44 percent. However, you could find that information in the prospectus for the fund. According to Yahoo Finance, the five-year average return for this fund is 17.43 percent.
The broker also doesn't tell you there are far less expensive index funds available which track the same index. For example, the Schwab S&P 500 Index Fund (SWPPX) has an expense ratio of a miniscule 0.09 percent. The five-year average return of this fund is 19.02 percent, handily beating the comparable return of the more expensive State Farm fund.
You would think omitting this information would violate anti-fraud rules promulgated by the SEC. After all, these are facts reasonable investors would find "material" and would put the information conveyed by the broker in an appropriate context. Yet, as far as I'm aware, the law has not been interpreted in this manner. The conduct of the broker, at least under current law, would be perfectly legal.
Although I can think of no reason other than superb marketing why any investor who seeks returns comparable to the S&P 500 index would invest in the State Farm fund, the numbers tell a different story. The net assets of this fund are in excess of $907 million.
Recommending actively managed funds. Now let's assume you go to your broker and ask his or her opinion for an investment in a large-cap fund that is benchmarked to the S&P 500 index. This time, you are open to either an index fund or an actively managed fund. The broker recommends an actively managed fund.
In connection with this recommendation, the broker does not give you historical data that would permit you to assess the odds that the more expensive actively managed fund will outperform the less expensive index fund. The prospectus he or she gives you from the actively managed fund does not contain this information, either.
Specifically, the broker does not tell you that for the five-year period ending in 2013, 72.72 percent of all large-cap funds were outperformed by their benchmark. If you knew this information, you would have selected a less expensive index fund that, after deducting low management fees, would likely earn returns close to its benchmark.
Once again, it’s difficult to understand why the omission of this information, which is obviously "material," doesn't violate the anti-fraud provisions promulgated by the SEC. As with the example above, I am unaware of any court that has ruled in this manner. Consequently, every day, investors make decisions without being given the totality of information that would permit them to make an intelligent and responsible choice.
Until such time as the law catches up with common sense, it’s your responsibility to be on the lookout for sharp practices in the securities industry.
Dan Solin is the director of investor
advocacy for the BAM ALLIANCE and
a wealth advisor with Buckingham. He is
a New York Times best-selling author of the Smartest series of books. His
latest book, "The Smartest Sales Book You'll Ever Read," has just